Germany's Teetering Banks

June 18, 2002

By David Fairlamb May 16 was a day that customers of Bank für Kleine & Mittlere Unternehmen, a small German bank, won't soon forget. In a stormy meeting with depositers in Berlin's Karl-Liebknect-Haus, bank board Chairman Marlene Kück declared that BKMU was bankrupt and the most the depositers could expect to get back would be the 20,000 euros ($19,000) guaranteed under the state-sponsored deposit-insurance scheme. "It's an absolute scandal," said Andreas Popp, a pensioner who claims that the bank's demise will cost him tens of thousands of euros. "I had always assumed German banks were as safe as houses. Then this happens."

In fact, German banks haven't been very safe at all of late. Recent months have seen a string of bankruptcies and near bankruptcies -- and financial experts caution that more could come.

"SHOCKING NUMBER." Just before BKMU closed its doors, Gontard & Metallbank, a Frankfurt-based deposit-taker that had grown quickly during the boom years of the Neuer Markt, declared bankruptcy, a victim of the downturn in the equity and initial public offering markets. Last November, Schmidt Bank, one of the country's oldest private banks, had to be rescued by a consortium hastily put together by the financial market regulators.

It subsequently emerged that the bank had lost 1.3 billion euros ($1.25 billion) during 2001, more than twice as much as had initially been expected. "A shocking number," says Paul Wieandt, who was brought in to salvage the ailing institution.

German prosecutors are now investigating the bank's former head, Karl Gerhard Schmidt. Just one thing is certain at this stage: 40% of all Schmidt Bank's loans -- largely made to the Middelstand, the midsize companies that form the backbone of the German economy -- have turned sour.

SPREADING WOES. It's not just small and private banks that have run into difficulties. Last year, Bankgesellschaft Berlin, the sixth-biggest bank in the country, almost collapsed under the weight of bad loans and had to be rescued by the city-state of Berlin with a capital injection of 1.7 billion euros ($1.62 billion). If the bank had gone under, it would have been the biggest financial-sector bankruptcy in Germany's history.

While most of the country's large publicly listed or government-owned banks are well capitalized and in no danger of collapse, problems have been mounting even there, too.

Bayerische Landesbank, the Munich-based bank that is 50% owned by the state of Bavaria, could lose up to 1 billion euros ($950 million) following the collapse of Kirch Group, the media empire to which it was heavily exposed. Other banks have also lost money because of Kirch and have been affected by the financial crisis in Argentina and the Enron collapse.

"VALLEY OF TEARS." Things could easily get worse. Creditreform, a research house that collects data on bankruptcies, predicts that the number of corporate insolvencies in Germany this year could rise by as much as 25%, to 40,000 this year. Banks have already increased their bad-loan provisions by an average of 10% in anticipation of a big rise in bad debts. "We'll go through the valley of tears," worries Deutsche Bank Chief Economist Norbert Walter.

Not surprisingly, banks have cut back dramatically on lending, threatening the country with a credit crunch just as it's beginning to claw its way out of recession. Net lending increased by less than 1% in April and May, according to Deutsche Bundesbank, the central bank. "We're threatened with being sucked into a vicious circle," says one banker in Frankfurt. "We don't lend because we fear bad debts, but that slows the economy and leads to more bankruptcies, which means our bad debts increase anyway."

Analysts say banks need to protect themselves by strengthening their balance sheets. But they can do that only if they boost their lackluster profitability. That's a tall order in a market that analysts think has too many banks. Return on equity at most German banks hovers below 10%, so investors aren't exactly eager to stump up new money. And profitability will increase only when the government-backed and state-owned savings banks that account for half of all lending are forced to compete on a level playing field with the private-sector banks and start making loans at normal market rates.

"ROUGH RIDE." Next, capacity must be taken out of the system by bank mergers and restructurings. German banks have been reluctant to merge, unlike their competitors in other European countries. As a result, their cost-income ratios are higher than those at their international competitors, and profitability is lower.

Many banks have started cutting costs. But driving up profits and restoring health to the banking sector will take time. In the meantime, other banks -- especially small institutions with limited capital -- could run into difficulties. Says the Frankfurt banker: "This is going to be a rough ride." The reputation of German banks being "safe as houses" will be tested as never before. Fairlamb covers the European banking scene for BusinessWeek from Frankfurt